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If you have used all of the room in your RRSP and TFSA, congratulations. Your next move is to build savings in a non-registered account, which means you’re dealing with the dreaded T-word: Taxes.
While the investment income you earn in a tax-free savings account, or TFSA, is never taxed, and income in a registered retirement savings plan, or RRSP, dodges taxes until the money is taken out, income you earn on investments in a non-registered account is not so lucky.
Taxes reduce the amount of money you have to invest and slows its growth, so it is important to consider tax in your non-registered account.
But tax should never be the number one driver of how you invest – it’s more important to have investments that meet your needs. The right mix of stocks, bonds and cash – your asset allocation – has to be appropriate for your time horizon and tolerance for volatility.
Swapping a stock market investment for a guaranteed investment certificate, or GIC, might be good for your tax bill, but it might be terrible for your financial plan.
Here’s a primer on how different types of investment income are taxed at different rates. Interest income, which you receive when you own GICs and bonds, is taxed just like employment income.
Capital gains – the money you make when the value of your investment goes up – are taxed at half of this rate, because you only pay tax on half of the gains. Even better, you don’t owe any tax on capital gains until you actually sell the investment.
Dividends are more complicated. Dividends paid by Canadian companies receive a tax credit, which offsets the amount of tax you have to pay. The extent of the tax savings depends on your total taxable income.
With this in mind, it would make sense to generate as little interest income as possible in a non-registered account because you will pay the highest tax rate on this kind of income. But remember, asset allocation comes first.
Money you will need in the near term – an emergency fund, a vacation, or a new car – needs to be in something safe such as a savings account, a GIC, bonds, a money market mutual fund, or a high interest savings exchange-traded fund, also known as an ETF.
These investments pay interest, but that’s fine: Asset allocation first, tax second.
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Holding interest-generating investments also makes sense for someone who can’t handle volatility in their investments, either emotionally or financially. Many older people are simply more comfortable with a safe investment.
Or it could be that they are at an age where they can’t financially afford to take on stock market volatility. It’s much more important that they feel comfortable with what they own, and that their money will be there when they need it, rather than save on taxes.
Younger people face the same dilemma. Saving for a down payment can mean having a lot of money sitting in a safe investment that pays interest and generates little to no growth.
There is very good reason for this – the last thing you want is to find the house of your dreams in the middle of a stock market crash, and realize that 20 per cent of your down payment has disappeared. That’s what could happen if you choose to invest in stocks, the more tax-efficient investment.
Dividends also provide tax-planning opportunities. Provinces differ in their dividend tax credit rates, but in most provinces, dividend income is subject to a low tax rate, even lower than capital gains, when you have a modest amount of total taxable income.
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In some provinces, people with low taxable income actually pay no tax on dividend income. At higher income levels, the tax rate on dividends rises.
Owning stocks, ETFs or mutual funds that pay a lot of dividends is attractive from a tax perspective, but it comes with downsides. If you want to take advantage of the dividend tax credit, you have to invest in Canadian companies. This means you will have an account full of insurance, pipeline, and telecom companies as well as banks, and not much of anything else.
This lack of diversification can mean lower returns. You could balance out your geographic exposure by owning foreign stocks in your RRSP and TFSA to offset this high exposure to Canada, but now things are getting a bit complex, requiring more effort from you.
While it’s worthwhile to think about the taxation in your non-registered account, remember your main objective: Investing your savings in a way that best serves your needs. If you pay a bit of tax to achieve this, that’s all right.
Anita Bruinsma is a Toronto-based certified financial planner at Clarity Personal Finance.
